360 Accountancy Financial Statements - II 10 n chapter 9, you learnt about the preparation of Isimple final accounts in the format of trading and profit and loss account and balance sheet. The preparation of simple final accounts pre-supposes LEARNING OBJECTIVES the absence of any accounting complexities which After studying this chapter, are normal to business operations. These you will be able to : complexities arise due to the fact that the process • describe the need for of determining income and financial position is adjustments while based on the accrual basis of accounting. This preparing the financial statements; emphasises that while ascertaining the profitability, • explain the accounting the revenues be considered on earned basis and treatment of adjust- not on receipt basis, and the expenses be considered ments for outstanding on incurred basis and not on paid basis. Hence, and prepaid expenses, many items need some adjustment while preparing accrued and advance the financial statements. In this chapter we shall receipts of incomes; discuss all items which require adjustments and • discuss the adjust- the way these are brought into the books of account ments to be made regarding deprecia- and incorporated in the final accounts. tion, bad debts, provi- sion for doubtful debts, 10.1 Need for Adjustments provision for discount on debtors; According to accrual concept of accounting, the profit • explain the concepts or loss for an accounting year is not based on the and adjustment of revenues realised in cash and the expenses paid in manager’s commission cash during that year. There may exist some receipts and interest on capital; and expenses in the current year which partially • prepare profit and loss relate to the previous year or to the next year. Also, account and balance there may exist incomes and expenses relating to the sheet with adjust- current year that still need to be brought into books ments. of account. Such items duly adjusted, the final accounts will not reflect the true and fair view of the state of affairs of the business. 2020-21 Financial Statements - II 361 For example, an amount of ` 1,200 paid on July 01, 2016 towards insurance premium. Any general insurance premium paid usually covers a period of 12 months. Suppose the accounting year ends on March 31, 2017, it would mean that one fourth of the insurance premium is paid on July 01, 2016 relate to the next accounting year 2017-18. Therefore, while preparing the financial statements for 2016-17, the expense on insurance premium that should be debited to the profit and loss account is ` 900 (` 1,200 – ` 300). Let us take another example. The salaries for the month of March, 2017 were paid on April 07, 2017. This means that the salaries account of 2016-17 does not include the salaries for the month of March 2017. Such unpaid salaries is termed as salaries outstanding which have to be brought into books of account and is debited to profit and loss account along with the salaries already paid for the month of April, 2016 up to Feburary, 2017. Similarly, adjustments may also become necessary in respect of certain incomes received in advance or those which have accrued but are still to be received. Apart from these, there are certain items which are not recorded on day-to-day basis such as depreciation on fixed assets, interest on capital, etc. These are adjusted at the time of preparing financial statements. The purpose of making various adjustments is to ensure that the final accounts reveal the true profit or loss and the true financial position of the business. The items which usually need adjustments are: 1. Closing stock 2. Outstanding/expenses 3. Prepaid/Unexpired expenses 4. Accrued income 5. Income received in advance 6. Depreciation 7. Bad debts 8. Provision for doubtful debts 9. Provision for discount on debtors 10. Manager’s commission 11. Interest on capital It may be noted that when we prepare the financial statements, we are provided with the trial balance and some other additional information in respect of the adjustments to be made. All adjustments are reflected in the final accounts at two places to complete the double entry. Our earlier example in chapter 9 (Page no. 336) which represents the trial balance of Ankit is reproduced in figure 10.1: 2020-21 362 Accountancy Trial Balance of Ankit as on March 31, 2017 Account Title Elements L.F. Debit Credit Amount Amount ` ` Cash Assets 1,000 Bank Assets 5,000 Wages Expense 8,000 Salaries Expense 25,000 Furniture Assets 15,000 Rent of building Expense 13,000 Debtors Assets 15,500 Bad debts Expense 4,500 Purchases Expense 75,000 Capital 12,000 Equity Sales Revenue 1,25,000 Creditors Liabilities 15,000 Long-term loan (raised on 1.4.2013) Liabilities 5,000 Commission received Revenue 5,000 Total 1,62,000 1,62,000 Additional Information : The stock on March 31, 2017 was ` 15,000. Figure 10.1 : Showing the trial balance of Ankit We will now study about the items of adjustments and you will observe how these adjustments are helpful in the preparation of financial statements in order to reflect the true profit and loss and financial position of the firm. 10.2 Closing Stock As per the example in chapter 9 (Page no. 336), the closing stock represents the cost of unsold goods lying in the stores at the end of the accounting period. The adjustment with regard to the closing stock is done by (i) by crediting it to the trading and profit and loss account, and (ii) by showing it on the asset side of the balance sheet. The adjustment entry to be recorded in this regard is : Closing stock A/c Dr. To Trading A/c The closing stock of the year becomes the opening stock of the next year and is reflected in the trial balance of the next year. The trading and profit and 2020-21 Financial Statements - II 363 loss account of Ankit for the year ended March 31, 2017 and his balance sheet as on that date shall appear as follows : Trading and Profit and Loss Account of Ankit for the year ended March 31, 2017 Dr. Cr. Expenses/Losses Amount Revenues/Gains Amount ` ` Purchases 75,000 Sales 1,25,000 Wages 8,000 Closing stock 15,000 Gross profit c/d 57,000 1,40,000 1,40,000 Salaries 25,000 Gross profit b/d 57,000 Rent of building 13,000 Commission received 5,000 Bad debts 4,500 Net profit (transferred to 19,500 Ankit’s capital account) 62,000 62,000 Sometimes the opening and closing stock are adjusted through purchases account. In that case, the entry recorded is as follows : Closing stock A/c Dr. To Purchases A/c This entry reduces the amount in the purchases account and is also known as adjusted purchases which is shown on the debit side of the trading and profit and loss account. In this context, it may be noted, that the closing stock will not be shown on the credit side of the trading and profit and loss as it has been already been adjusted through the purchases account. Not only, in such a situation, even the opening stock will not be separately reflected in the trading and profit and loss account, as it is also adjusted in purchases by recording the following entry: Purchases A/c Dr. To Opening stock A/c Another important point to be noted in this context is that when the opening and closing stocks are adjusted through purchases, the trial balance does not show any opening stock. Instead, the closing stock shall appear in the trial balance (not as additional information or as an adjustment item) and so also the adjusted purchases. In such a situation, the adjusted purchases shall be debited to the trading and profit and loss account. 2020-21 364 Accountancy The closing stock shall be shown on the assets side of the balance sheet as shown below: Balance Sheet of Ankit as at March 31, 2017 Liabilities Amount Assets Amount ` ` Owners funds Non-Current Assets Capital 12,000 Furniture 15,000 Add Net profit 19,500 31,500 Current Assets Non-Current Liabilities Debtors 15,500 Long-term loan 5,000 Bank 5,000 Current Liabilities Cash 1,000 Creditors 15,000 Closing stock 15,000 51,500 51,500 10.3 Outstanding Expenses It is quite common for a business enterprise to have some unpaid expenses in the normal course of business operations at the end of an accounting year. Such items usually are wages, salaries, interest on loan, etc. When expenses of an accounting period remain unpaid at the end of an accounting period, they are termed as outstanding expenses. As they relate to the earning of revenue during the current accounting year, it is logical that they should be duly charged against revenue for computation of the correct amount of profit or loss. The entry to bring such expenses into account is : Concerned expense A/c Dr. To Outstanding expense A/c The above entry opens a new account called Outstanding Expenses which is shown on the liabilities side of the balance sheet. The amount of outstanding expenses is added to the total of expenses under a particular head for the purpose of preparing trading and profit and loss account. For example, refer to Ankit’s trial balance (refer figure 10.1). You will notice that wages are shown at ` 8,000. Let us assume that Ankit owes `500 as wages relating to the year 2016-17 to one of his employees.